Islamic Bank Failure: A Case Study

Mahmood Nathie

Abstract
Recent turmoil in financial markets has once again emphasised the need for
regulatory vigilanceespecially in relation to banks in distress and those
experiencing a run on depositors funds. The Islamic Bank Ltd of South Africa
collapsed in 1997, and its failure exposed the cost of bad credit risk
management, operational dysfunction and regulatory breaches. This study
finds early regulatory intervention may have addressed major liquidity
shortcomings and perhaps even forestalled the banks collapse. Despite
effective intervention measures, the evidence shows a run on funds fuelled by
noise and loss of confidence is difficult to reverse without direct and
significant central bank liquidity infusion and deposit guarantees. Evidence of
poor management and dereliction of duty by external auditors to report on
material irregularities reinforces the need for a new whole-of-regulatory
approach. Further, Shariah compliance is found to be ineffectual without
substantive legal support.

Key words: Failure; bank runs; Shariah compliance; accounting

Introduction

Banks in distress present a threat to orderliness and stability in financial markets. Left
unresolved, users and providers of funds in distressed banks quickly respond to
uncertainty, rumours and loss of confidenceall combining in precipitating a run on
depositors funds. Evidence suggests that during bank runs, depositors fail to
distinguish between good and bad banks (Hasan & Dwyer, 2007; Chen & Hasan,
2008). This behaviour was exemplified in the collapse of Islamic Bank Ltd (IBL) in

Mahmood Nathie is a Research Fellow attached to the Griffith Islamic Research Unit at Griffith
University in Brisbane, Australia. He can be contacted at mnathieacademic@gmail.com

South Africa in 1997. Associated with this failure was the seriousness of the bank run
on murabaha-contracted deposits first occasioned by noise, then opaque operational
information, lack of confidence and finally contraventions of law, dodgy accounting,
poor operational practices and Shariah non-compliance.
The result of IBLs collapse showed up in reputational damage to the nascent
development of Islamic finance in that country (Loonat, 2004). Its failure was not
occasioned by lack of faith in Islamic finance, but a lack of good governance and
management practices revealed in the South African Reserve Banks (SARB)
Inspectors Report (IR).1 Reacting to rumours, IBL management unconscionably
assured that depositors savings were safe while the opposite prevailed. The banks
largest Shariah attenuation was accumulating riba-based property debt which,
weighed against its heavy promotion of Shariah compliance, was at odds with its own
ethical charter and public image.
This paper presents evidence of the causes and consequences of the banks
collapse. The next section deals with a review of the literature on bank failure with a
focus on experiences in South Africa. Thereafter follows a discussion on methodology
and data. Finally, empirical evidence is presented together with a discussion of the
implications of bank failure for Islamic finance.

Literature on financial distress and bank failure

With the exception of a study by Ali (2007), few studies focus attention on distressed
and failed Islamic financial institutions and systematic approaches for analysing
failure through distress prediction models. On the contrary, there is formidable and
substantive literature dealing with conventional bank distress and failure. The
academic remit embraces economic models (Diamond & Dybvig, 1983); bankruptcy
prediction models (Altman, 1968; Zavgren, 1983; Zmijewski, 1984; Sharma, 1999);
causality analysis (Schiff & Downes, 2007; Shiller, 2008) and ratio analysis (Beaver,
1966). Given the absence of adequate Islamic finance models, conventional financial
models are convenient starting points for use in analysing Islamic bank failures.

The Inspectors Report dated 20 November, 1997 (Louw and Jaffer of accounting firm KPMG)
pursuant to an order by the High Court of South Africa (Registrar of Banks v Islamic Bank Ltd, Case
No 25286/97) on 31 October, 1997 authorising the Inspectors to perform an inspection of the books of
Islamic Bank Ltd in relation to its risk management systems and books of account.

The seminal economic model on bank runs is that of Diamond and Dybvig
(1983). Their theory postulates that depositors are predominantly liquidity focused,
are impatient to consume and therefore prefer investment in liquid assets (Wallace,
1988). Without easily accessible and sufficient liquidity, unless underpinned by
deposit insurance or mechanisms for suspension of payments in contingencies, bank
runs will always remain a threat (Green & Lin, 2000). Consequently, it is argued that
demand deposits contracts are credible ways of forestalling runs (Bryant, 1980).
However, where contracts and deposit insurance are absent, the likely but undesirable
outcomes are accelerated runs on bank liquidity since depositors expect the distressed
institutions to fail (Diamond & Dybvig, 1983). Fuelled by noise, rumours and
negative expectations, the run on funds commences sooner than expected (Chen &
Hasan, 2008) and, without large liquidity infusion, quickly triggers collapse (Bryant,
1980; Huo & Yu, 1994).
In predicting failure, it is argued that such models are largely dependent on the
quality of financial information such that, data that is essentially dirty produces
erroneous results (Sharma, 1999, p. 64). Further, Sharma (1999) argues that
management of failed enterprises very often resort to creative accounting to conceal
firstly, performance and thereafter the true extent of financial problemsa practice
resulting in imaginative accounting (Stewart, 2006). Naser and Pandlebury (1992)
find that the use of creative accounting is often resorted to, to portray favourable
impressions in debt covenant obligations. Furthermore, enterprises (such as Enron)
often resort to creative bookkeeping because of their own awareness and realisation
that they are failing (Stewart, 2006, p. 116). Amat, Blake and Dowds (1999) conclude
that the common view in many studies suggests creative accounting practices are
deceitful, unethical and unjust to stakeholders. More recently, de la Torre (2009)
argues, from an extensive examination of annual reports of major corporations, how
carefully crafted accounting methods and glossy presentations are employed to
deceive readers of financial statements while questionable disclosure practices are
used to present favourable images of otherwise bad operating results.
Bank runs may be isolated, but may also be contagious and result in economic
cost across the industry (Hoggarth & Saporta, 2001). In relation to Islamic finance,
Nienhaus (1986) cites financial distress experiences associated with Kuwait Finance
House (KFH), which suffered heavy losses due to large exposure to the construction
industry in 1984. Grais (2004) ascribes the KFH losses to the crash of the Souk al3

Manakh2 in Kuwait. Another bank in distress was the Islamic International Bank of
Denmark that lost more than 30% of its equity between 1985 and 1986 which Grais
(2004) blames on excessive risk-taking and heavy exposure to a single borrower.
However, the collapse of Ihlas Finance House3 (IFH) in Turkey in 2002 represents the
most serious case in Islamic bank failure (Ali, 2007). Evidence shows IFHs collapse
was precipitated by a combination of risky lending, rapid expansion, questionable
central bank regulation and the overtly negative political postures towards Islamic
finance.
In relation to bank failures in mature economies, a report by the Bank for
International Settlements (2004, p. 66) identifies real estate lending as a major cause
of bank failures. The report also finds that one-off failures are not tied to economic
conditions but to bad credit risk and the failure of banks true capital positions caused
by accounting and valuation inadequacies.

Background to bank failures in South Africa

A number of banking institutions have failed over the past years, and this has been
primarily associated with frauds, liquidity runs and poor management (Okeahalam,
1998). Nonetheless, this tendency has not resulted in major banking crises, according
to Falkena, Bamber, Llewellyn and Store (2001), given a long history of bank failures
in that country (Ngaujake, 2004). As a result, the SARB4 has been increasingly
reluctant to support failed banks.5
Research associated with South African bank failure falls into a mixture of
categories. Studies by Okeahalam (1998), Okeahalam and Maxwell (2001) and
Manuel and Mboweni (2002) suggest failures occasioned by fraud and insider lending
2

Around September 1982 Kuwaits Souk al-Manakh (an unofficial over-the-counter stock market)
collapsed driven by highly speculative short sales associated with a small group of dubious and
unregulated Kuwaiti companies some incorporated in Bahrain and the UAE. The bull run for stocks
of these companies commenced with investors using post-dated cheques to settle deals. The collapse
started when banks refused to encash these cheques and defaults on margin calls. Other reasons
included the refusal of the Kuwaiti authorities to grant corporate charters to other companies thereby
narrowing the equity universe available to the public.
3
The collapse of this Islamic bank was precipitated by liquidity problems, mismanagement and abuse
of depositors funds (see The Economist (US) February 17, 2001, Full of interest; A Turkish bank
collapses (Ihlas Finans))
4
As a lender of last resort as well as guarantor in the absence of deposit-insurance protection
5
Although in the case of IBL, the Minister of Finance agreed to a maximum ZAR50 000 compensation
per individual motivated by the necessity to instil financial stability in the market (SARB Bank
Supervision Annual Report, 1997)

include the collapse of Alpha Bank, 1990; Cape Investment Bank, 1991; Islamic Bank
of South Africa, 1997; Regal Treasury Bank, 2001; and Saambou Bank, 2001.
Failure attributed to liquidity runs and poor management identified by Ngaujake
(2004) include Pretoria Bank, 1991; Prima Bank, 1994; African Bank, 1995; and
Board of Executors, 2002 and the Islamic Bank of SA, 1997.
These failures share a number of commonalities. First is the slow
responsiveness by regulators (the SARB, corporate regulators and tax authorities) to
identify liquidity and reporting problems through early distress modelling, regulatory
breaches and tax non-compliance (Okeahalam, 1998; Okeahalam & Maxwell, 2001).
These researchers are highly critical of procrastinatory interventionist measures by the
regulatory authorities to respond to bank crises. They cite the Regal Treasury Bank
case in which the Registrar of Banks (RoB) was powerless to remove the sole director
of the bank despite hard evidence of fraud and corporate malpractice (Ngaujake,
2004, p. 92). Other common failure and distress themes identified by Ngaujake (2004)
include poor liquidity, mismanagement, fraud and importantly, insider and unsecured
lending. Unsecured lending includes management-related personal loans and blatant
nepotism in credit advances. Brownbridge (1998, p. 182) finds a positive relationship
between these variables and bank financial distress from a study of cases in selected
African countries.

Methodology and Data

4.1

Methodology

In analysing failures, causality models are essentially after-the-failure analysis in

which quantitative financial relationships provide empirical evidence for which no
theoretical support exists ex ante (Sharma, 1999). However, most studies seem to
favour prediction models that rely on ratio analyses in evaluating the financial
stability of banking institutions (Cihak & Hesse, 2008). Altmans (1968) z score
provides a departure in bankruptcy prediction since it uses both qualitative variables
and a number of financial ratio variables in multiple discriminant analysis to predict a
company's probability of failure. Generally, the lower the z score the more likely the
firm will fail. This methodology is adopted by Cihak and Hesse (2008) in their
analysis of Islamic bank financial stability. Beaver (1966) however, proposes
univariate models relying on thirty standard accounting and financial ratio analyses in
5

financial stability analyses. Leaving aside most other ratios, Beaver (1966) concludes
that the cash flow/total debt ratio is the single best predictor of failure.
In general however, error rates in predicting failures using these models
increase as time to bankruptcy increases (Estrella, Park & Peristiani, 2000; Samad,
2004; Sharma, 1999). More recently Kolari, Glennon, Shin and Caputo (2002) added
more advanced quantitative approaches in bank failure prediction models. An easier
measure of bank failure (though not as robust as other models) is the so-called
Texas ratio proposed by Jesswein (2009). This ratio is expressed as: nonperforming loans-to-equity + reserves. Generally, the closer this ratio approaches 1:1,
the greater the likelihood of bank failure. In essence, Jesswein (2009) argues that a
close watch on the deteriorating performance of this ratio by regulators would provide
sufficient justification for early and more interventionist measures. There has been
mixed response to the reliance on this ratio, but Jesswein (2009) notes its success in
failure prediction used by other researchers in the US relying on US Federal Deposit
Insurance Corporation data.6
The framework for this study embraces a combination of models relative to
failure measurement comprising: a listing and transactional approach suggested by
Ali (2007); financial ratio analysis (Sharma, 1999) and, a compliance approach
suggested by this study. The first approach relies largely on case study whereby
plausible causes of failure are identified (Ali, 2007, p.3). The second is a more
generic approach while the third draws on content analysis of litigation documents,
media coverage, liquidation reports and judicial investigations. Compliance in this
study assumes a two-fold approach: the first relates to actions taken by regulators and
the second, by actions of Shariah advisory boards. The compliance approach
incorporates changes in socio-economic behaviour; civil actions; press coverage and
adverse publicity.

4.2

Data

The data for ratio analyses relies on IBLs annual reports for the ten-year period 1988
to 1997 and Financial Position reports submitted to the court by the SARB
inspector immediately prior to liquidation. The SARB report provides much detailed
financial and accounting data compared to scant and negligible disclosures in IBLs
6

The author refers to problem banks placed on a watch list that subsequently faced closure
http://bankimplode.com

annual reports for all the years from inception to demise. For content analysis, this
study relies on court documents filed by the Registrar of Banks (RoB) with the High
Court of South Africa7 and annexures thereto. The study also relies on personal
interviews with Shariah scholars, the SARB-appointed inspectors and third parties
(depositors) affected by IBLs collapse. Valuable information was accessed from the
current database of monthly returns submitted by banking institutions to the SARB.8
Finally, this study relies on valuable information from correspondence between IBL
and various stakeholders as well as information from personal interviews.

Results

Following Latters (1997) listing approach of causality relied on by Ali (2007, p. 33),
details of IBLs collapse are now dealt with.
5.1

Unique circumstances

The IBL was accorded banking status in 1988. Its application for a banking licence
was largely acceded to through private promptings and (ostensibly) favourable
community dispositions. Although some reservations were expressed by the regulator
(as Islamic finance was an untested concept in the South African financial markets at
the time), the granting of a licence was seen as an initial test case for the introduction
of Islamic finance (SARB Annual Report, 1988). Accordingly, IBL was granted a
conditional (restricted) banking licence.9 This fact notwithstanding, as a new entrant
to the market essentially promoting a new banking ethos and novel ideas, there was an
implied obligation on IBL as an Islamic institution, to uphold Shariah ethics and
prudential standards through its role as a custodian of depositors funds (Chapra,
1985; Siddiqi, 1981). This argument is advanced first, because of the fiduciary duty
of care principle in fiqh muamalat as the mustawda (custodian) of depositors funds
(Ayub, 2007) and second, the necessity to dispel reputational damage caused by the
collapse of an earlier (purportedly Islamic) non-bank financial investment institution
in South Africa (Vahed & Vawda, 2008).10

The Registrar of Banks v The Islamic Bank Ltd, TPD, Case No: 27893/97
http://www.reservebank.co.za/internet/Publication.nsf/LPTV/Publications+&+research
9
It was not accorded a full general bank status (SARB Annual Report, 1988/9).
10
The reference is to the collapse of Jaame Ltd, a community-based investment company constituted
on Islamic compliance principles.
8

An oft-forgotten rule in banking is that banks are prone to runs (Ali, 2007;
Bryant, 1980). In IBLs case, the SARB concern was to stave off probable contagion
to other banks through bank inter-connectedness and by the unlocking of a
concatenation of cross claims and litigation (Wiese, 1997, p. 10). The latter raised
the spectre of collateral damage to other institutions if IBL was not wound up as a
result of its insolvent position.11 Further, the SARB was desirous of upholding
prudent banking practices pursuant to its obligations under the first Basle Accord.
Wiese (1997) argued that the RoB relied on Core Principle 22 of the Basle Committee
on Banking Supervision (1997)12 code that provides (under the heading Formal
Powers of Supervisors) sufficient guidance for regulators to act decisively where
prudential standards are breached or the interests of depositors are threatened. Core
principle 22 states:

Banking supervisors must have at their disposal adequate supervisory measures to bring
about timely corrective action when banks fail to meet prudential requirements (such as
minimum capital adequacy ratios), when there are regulatory violations, or where
depositors are threatened in any other way. In extreme circumstances, this should include
the ability to revoke the banking licence or recommend its revocation.

As IBL was in breach of a number of statutory requirements, the RoB relied

on Core Principle 22 in its submission to wind up IBL.

5.2

Ratios as predictors of bank failure

The use of ratios provides one of several measures in detecting early financial
distress. Table 1 outlines pertinent performance ratios in relation to IBLs position.
In general, the liquidity ratios indicate a consistent pattern of decline since
1988. The high NA/TA ratio is indicative of liquidity stress since a high proportion of
assets are tied up in customer advances suggesting the unlikely probability of quick
collection. The LA/DSTL may be conceived as an acid test and deposit run ratio. The
decline shows IBL was vulnerable to bank runs since liquid assets were unable to
meet unexpected mass withdrawals. The NA/TAB ratio indicates IBLs practice of
tying up more customer deposits in non-liquid assets. The higher this ratio, the greater

11

See RoB submission to the High Court of South Africa, November 20, 1997 as well as the 2007
Annual Report of the SARB Supervision Department.
12
See Core Principles for Effective Banking Supervision. Retrieved July 10, 2009 from
http://www.bis.org/publ/bcbs30a.pdf?noframes=1

the indications of liquidity risk this shows up in the progressive increase from 1988
to 1995.

Table 1

Islamic Bank Ltd distress ratio analysis

Ratio analysis
Liquidity Performance
Net Advances/Total assets
Liquid assets/Deposits &
short term loans
Net Advances/Total
deposits + borrowings
Credit Risk
Performance
Equity/Total assets
Equity/Net advances
Total impaired
loans/Gross advances
Texas Ratio
Non-performing
loans/Equity + reserves

Label

1995

1994

1993

1992

1991

1990

1989

1988

NA/TA
LA/DSTL

0.733
0.105

0.692
0.135

0.604
0.052

0.798
0.108

0.659
0.137

0.631
0.146

0.606
0.140

0.781
0.478

NA/TAB

1.126

1.160

1.282

0.880

1.107

0.970

0.696

0.587

E/TA
E/NA
IMP/GA

0.174
0.237
0.108

0.197
0.285
0.135

0.227
0.375
0.053

0.299
0.375
0.077

0.274
0.415

0.351
0.556

0.529
0.874

0.494
0.633

0.456

0.473

0.142

0.205

Note: Figures reported in IBLs annual reports have been adjusted to account for non-performing loans and asset
impairments. The ratios selected for analysis follow those employed by Samad (2004).

The credit risk performance ratios are a further indication of poor credit
management. The worsening E/TA ratio demonstrates less likelihood of absorbing
asset losses through shareholder equity. Further, the E/NA ratio show IBLs equity
did not provide sufficient capacity to absorb losses arising from customer loans and
advances. Further, IBL window-dressed its account through non-disclosure of
contingent liabilities associated with third party guarantees.
The increase in the Texas ratio above the 40% threshold, as argued by
Jesswein (2009), was a clear indicator of financial distress. In fact, this ratio
deteriorated to .686 (not shown in Table 1) for the period immediately preceding the
banks collapse. Thus there is, based on this ratio, sufficient justification for
regulators to use the Texas ratio in placing problem banks on watch (Jesswein,
2009).

5.3

Poor management and credit risk problems

Directors occupy a waadh (custodial) and fiduciary relationship with the bank. This
compels banks to act honestly and in good faith, for the benefit of depositors and in

performance of their duties.13 A careful study of the credit risk performance in Table
1 indicates a serious dysfunctional credit risk regime. Management was more
concerned with nurturing dubious real estate development than attending to day-today perfunctory matters such as cash flow and credit management.
Dubious of its management practices, reporting standards and deceptive
behaviour, the SARB took upon itself to obtain financial information from external
sources other than IBL.14 This cause of action was resorted to presumably because of
frustration by the reserve bank to obtain accurate and meaningful information from
the management of IBL.15 In their report, the RoB inspector noted:

Based on my inspection of the DI returns and particularly DI 200, it is clear that

representations are being made to the Registrar of Banks which are clearly false and
misleading (p. 12).

There was also a presumption that political pressure may have been exerted on
the regulator in not acting early and decisively (Okeahalam, 1998, p. 29).
Furthermore, Okeahalam (1998), reports that:
The management of IBL hid behind the self-regulatory position accorded to true Islamic
banks, and that in any event, given that it was operating in South Africa it was unlikely
to be able to operate as a true Islamic bank and that the RoB and the SARB should have
been more vigilant (p. 32).

As to poor management, the inspectors report (IR) confirmed IBL was

bankrupt by end September, 199716 partly occasioned by large insider and unsecured
lendingcauses identified by Okeahalam (1998) and Ngaujake (2004) in other bank
collapses. The IR also found poor control over the deposit base and customers
advancesfor instance, term deposit refunds were made without recourse to
contracted deposit arrangements while advances to friends and associates were not
collected for up to four years preceding collapse. Despite this, the published accounts
did not disclose any provisions for non-performing and non-recoverable debts. Yet
13

Section 60(1) of the South African Banks Act 90 (1989)

In the 2007 Annual Report of the SARB Supervision Department, the Registrar reported: As part of
the Bank Supervision Departments ongoing process of obtaining and analysing information on IBL,
the SARB appointed two [SARB] employees as inspectors in terms of the section 11 of the South
African Reserve Bank Act 1989 in order to obtain financial information on IBL from sources other
than IBL itself.
15
This is evident from correspondence between IBL and the RoB dated September 23, 1997 (see
Annexure CFW 4.3 to the Inspectors Report).
16
The High Court of South Africa granted an order on January 13, 1998 whereby IBL was placed in
final liquidation The Registrar of Banks v Islamic Bank Limited [HC WLD, Case 27893/97].
14

10

non-performing loans constituted 30.3% of total advances while only 44.5% of loan
advances were backed by credible securities. The IR also uncovered blatant
nepotismevident in large exposure to a small group of management and familyrelated parties revealed in the ratio of large advances/total advances of 36.7% at
date of liquidation.

5.4

Material irregularities, non-compliance and accounting shortcomings

Early signs of poor management and debt stress are revealed in critical ratio analysis
(Sharma, 1999). The latter argues that companies are prone to window dress results
to mar and understate bad performance. A serious precursor of bankruptcy is the
obfuscation of financial position through creative accounting (Mathews & Perera,
1996; Naser & Pendlebury; Sharma, 1999). The most serious aspects relate to early
and questionable revenue recognition and the practice of shifting items off balance
sheet to improve the balance sheet (Stewart, 2006).17 Manipulating accounting
figures, as IBL resorted to in the period close to liquidation, is not new and has
developed into an art form in itself, according to Amat, Blake and Dowds (1999).
A large proportion of IBLs earnings were derived from trade-related
murabaha contracts and real estate contracts with loan tenure spread over lengthy
periods. This serious cash-flow mismatch meant short-term borrowings (deposits)
effectively funded (real estate) long-term contracts. Further, these contracts inherently
included deferred revenue imprudently recognised by IBL immediately at date of
contract, instead of revenue smoothing through systematic recognition over the
contract tenure as prudent accounting suggests. Essentially, in the way Islamic
deferred sale contracts are structured, benefits (profit) payable to depositors should
be derived from income actually earned. The IR reveals substantial benefit
payments to depositors were derived from unearned profits or effectively,
distributions made out of capital. Hence reported earnings were inflated for every year
of IBLs existence.
The annual reports were also silent on the cession of IBLs book debts and
collateralised fixed property to other banking institutions to secure riba-based loans.
The raising of riba loans principally breached Shariah rules that effectively
17

Stewart (2006) reports a number of ruses employed by Enron including: accounting upfront for
substantial future earnings; reporting earnings of unproven ventures; and revenue recognition based on
unrealised third party performance obligations

11

constituted the antithesis of Islamic financial norms and practices. In addition,

securing riba-based loans subordinated the status of older and earlier genuine debt
held under murabaha muqayyadah and murabaha mutlaqah term deposits
(Obaidullah, 2006; Ayub, 2007; Khir, Gupta & Shanmugam, 2008). Further, IBLs
risk-weighted capital adequacy ratios were negative at -1.2% whereas the required
minimum was set at 8%.
The SARB DI200 monthly returns18 indicate these returns were window
dressed to display compliance. Another practice uncovered related to the erosion of
shareholders funds whereby R12.14 million was fictitiously credited to share
capital with the corresponding debit entry shown as a fictitious suspense account
asset. Such behaviour constituted a blatant contravention of section 38 of the South
African Companies Act 61 (1973).
Other irregularities included breaches of regulatory provisionsin particular,
the immediate notification to the regulator when banks experience runs on demand
deposits. Evidence shows large withdrawals prior to liquidationa practice
reminiscent of oppressive conduct against small depositors in the sense that large
depositors closely associated with management were preferred over other claimants in
relation to demand deposit covenants. This practice effectively constituted
unconscionable conduct whereby predominantly family and friends were accorded
preference ahead of the general body of depositors.

5.5

Evidence of non-compliant Shariah products

Table 2 sets out selected instances of Shariah non-compliance engaged in by IBL.

The extent of non-compliance is evident from selected cases set out in Table 2.
It is no surprise that as a result IBL did not have the support of the Shariah advisor nor
of the wider Muslim community (Inspectors Report, p.13).

18

This return shows detailed monthly Income Statement items net income after provisions for
taxation and transfers to reserves.

12

Table 2 Selected cases of Shariah product non-compliance

Product type

Non-compliance

Deposit accounts
Amanah Funds (custodial)only to be used as
directed

Covenant not adhered to as funds were mixed

with normal deposit accounts

Murabaha deposits

Finance products
Murabaha contracts
Short-term murabaha contracts
Long-term murabaha real-estate contracts

Rabb al-mal liable for losses but losses not

allocated to depositors
Losses due to negligence not absorbed by bank
Used in bill discounting
No contracts in place
Convoluted transactions. Interposed entity used to
buy property not controlled by IBL. Real estate
then on-sold to related parties using conventional
riba contracts

Regulatory supervision

In keeping with prudent regulatory tradition established in Islamic banking

(DeLorenzo, 2004), IBL did appoint a Shariah advisory council (SAC) as supervisor
to oversee its compliance obligations. A keen observer may however, question why
three external supervisory bodies (the SARB; the SAC; and the external auditors)
charged with regulatory enforcement, ethics and reporting were ineffectual or failed in
their duty to anticipate or prevent the collapse. Okeahalam (1998) criticised the SARB
supervisory division for its lack of timely and effective intervention. Admittedly, the
SARB did act, albeit very timidly, when liquidity problems first emerged. However,
as Ali (2007), Henry and Wilson (2004) and Warde (2004) argue, the dynamics of
politics and social concerns often resist quick and decisive action.19 Thus regulators
may initially resist staving off bankruptcy for reasons unrelated to prudential
supervision (cf. the Lehman Bros collapse) and sometimes react irrationally for
political expediency as in Turkey (the Ihlas Finans case) and Egypt (the Nasser Social
Bank case) (Henry, 2004; Soliman, 2004). However, some blame may be attributed
to the RoB itself for purporting to show IBL complied with prudential
requirements20yet failed in Nov 1997.
In his critique of Shariah scholars, Kahf (2004) argues that many Shariah
scholars charged with supervisory duties do not adequately fulfil their function for
lack of knowledge of complex financial dealings and mathematics. Furthermore,
19

This was clearly the case with problem banks in Egypt, the UAE, Turkey and Kuwait (Henry &
Wilson, 2007; Grais, 2004).
20
Evident in a statement dated October 2, 1995.

13

scholars serving on SACs may compromise their supervisory functions where their
appointments carry lucrative remuneration. In IBLs case, Shariah scholars did raise a
number of non-compliance issues. For lack of authority, the scholars concerns were
ineffectual as the SACs role was confined to perusing product compliance and not
breaches of law. The SAC raised problems related to dividend calculations, ribarelated financing and aspects of product compliance. For instance, in March 1992 the
IBL SAC expressed serious misgivings in relation to IBLs profit distributions and
product non-compliance.21 By November 1996 the SAC advised IBL that it fell afoul
of its Shariah compliance duties, in its lending practices and of the widespread
disenchantment in the Islamic community. The SAC alerted IBL of these breaches in
1991 and regularly thereafter. In its deliberations in September 1995, the SAC made it
clear that it preferred to deal with Shariah breaches directly with management to avert
adverse publicity but that it was also duty-bound to uphold its responsibility to
depositors, shareholders, creditors and the wider Islamic community. Since remedial
action was not forthcoming, nor contemplated, the SAC withdrew its approval.22 In
contrast, IBL consistently held out that its finances were in order, issuing statements
to the effect that we are pleased to report that the Islamic Bank has successfully
restored its deposit base and liquidity.23
In relation to IBLs external auditors, the IR report as well as the SARB Bank
Supervisory Department24 expressed gross dereliction of duties by the auditors. The
latter department noted serious incompetencies with the banks auditors, in particular
its failure to report major shortcomings in the statutory returns of IBL and
significant transgressions of the Banks Act (p. 2). A final and damning finding by the
inspector was the parlous state of IBLs accounting and management records. In
particular, the loan/advances ledger did not reconcile with amounts disclosed in the
annual financial statements. The auditors did not report on these facts and breaches of
the Companies Act.

Implications of the IBL collapse

Limiting bank failures is the primary objective of regulatory authorities (Miller & Van
Hoose, 1997, pp. 204-206). IBLs collapse highlight many issues not properly
21

Evident in minutes of meetings between IBL and its SAC during September 26, 1995
See public announcement by The Jamiatul Ulama published in Ar-Rasheed (April, 1997).
23
Official statement by IBLs CEO, March 1997
24
Wiese (1997) Annual Report, Reserve Bank of South Africa
22

14

understood and appreciated, e.g. the role of the Reserve Bank as lender of last resort;
deposit insurance and the upholding of Shariah principles. The first measure is aimed
at restoring liquidity while the second is aimed at protecting depositors. While the
Shariah is not explicit on both issues, the imperatives of applying pragmatic
alternatives based on maqasid make a compelling case for some form of depositor
protection. However, Okeahalam and Maxwell (2001) argue that given experiences of
bank collapses globally, deposit insurance may prompt banks to take on greater risks.
Until then, risk insurance will remain a problem for Islamic financial institutions.
A further consequence of the IBLs failure was the reputational damage to
Islamic finance. Loonat (2004) argues that negative embellishments of the type
displayed in IBLs managerial behaviour stigmatised genuine Shariah alternatives to
riba-based finance. This brings into perspective the Shariah rule that mudaribs (the
directors of IBL) owe a fiduciary duty to investors and third parties. Hence they are
liable for losses, where negligence or dishonesty are proven or shown to exist
(Usmani, 1998, p. 48). In Carrim v Omar [2001 (4) SA 691 (W)] the applicant (a
director of IBL), who was sued for losses suffered by the respondent for guarantees in
relation to IBLs financial position, failed in his attempt to have an earlier lower court
decision overturned. The respondent succeeded in its initial claim in recovering
monies invested on the basis of assurances give by the applicant on the financial
standing of IBL.25 In the appeal case Carrim v Omar (supra) the decision confirmed
the contractual (murabaha) principle of providing for eventualities relating to both
profits and losses implying thereby that losses resulting from negligence would be
upheld in common law.
A further consequence of fiduciary responsibility is the reinforcement of the
istisna principle in Shariah-based contracts and its parallel with the secular
25

The case cited was an appeal against an earlier lower court judgment in favour of the respondent. In
the original case the respondent sought restitution of monies invested in the failed Islamic Bank Ltd
relying on an oral agreement whereby the appellant bound himself as guarantor for indebtedness of the
bank to the respondent. The court accepted that an unrestricted Mudarabah contact created a
relationship between the bank and the investors that was different in principle from that created when a
person deposited money in an ordinary non-Islamic bank and that the essence of the contract between
investor and bank was one of partnership creating eventualities. The presiding judge held (at 732) that
the guarantee made it possible to invest with [IBL] on the mudarabah contract without the possibility
of suffering any loss. Held further (at 739) that the appellant was obliged to pay the respondent what
the bank was obliged to pay [the respondent] as the agreement alleged by the respondent made it clear
that the appellants liability would arise even in circumstances where the bank was not obliged to make
any payment in terms of the mudarabah contract.

15

common law equity principle.26 Both concepts are inspired by fairness and conscience
(Kamali, 2004). This position27 was clarified in the Malaysian case Malayan Banking
Bhd v Yakup bin Oje & Anor [2007] 6 MLJ 389 (p. 4). These legal parallels have been
discussed in legal deliberations28 and critiqued by DeLorenzo and McMillen (2007).
These scholars argue that fairness in finance and trade practices do prevail under
both legal systems especially in relation to legal disputations and conflict but that
secular courts place greater relevance on their own common law as evidenced in
decisions in other jurisdictions.29
This raises an interesting issue on the equity side of an Islamic banks balance
sheets and the inter-relatedness of failure with the application of the istisna principle.
Given the formal-legalistic relationship between a bank and murabaha accountholders (MAH) as rabb al-mal,30 equity-based investments (as In IBL) are always at
serious risk of being relegated in preferential standing in bankruptcy claims (ElGamal, 2005). In IBLs case, claims of secured creditors ranked ahead of others
despite the fact that it was MAH and investment account holders (IAH) funds that
sustained the bank since inception. That position in itself presents a serious challenge
of the istisna principle based solely on risk exposure (El-Gamal, 2005).31 The IBL
collapse shows that in todays corporatised Islamic banking environment, it is
manifestly unjust that MAH and IAH holders have little recourse in preferential
ranking when bank runs and insolvency are imminent when occasioned by third party
default and bad management. In what followed in the IBL winding-up process, the
liquidator simply set aside the special Shariah contractual murabaha arrangements
and proceeded to accord preferential status pursuant to South African law thereby
26

See especially the Quranic verses: Maidah 5:8 and an-Nisaa 4:135 and Kamali (2004, pp. 245266).
27
In this case Abu Backer, J held (at 5) of his judgement : there is no legal prohibition under our
procedural law for the judge to direct compliance of the [common law] rules as near as possible with
necessary variation as the justice of the case may require (emphasis).
28
See ISRA Monograph Series 1.
29
In considering this juristic interplay it is worth noting the decision in Shamil Bank of Bahrain EC v
Beximco Pharmaceuticals Ltd (No.1), [2004] EWCA Civ 19; [2004] 1 W.L.R. 1784. In this case
shariah-compliant agreements were accepted as properly constructed but that in relation to disputes
between the parties preferring adjudication under English jurisdiction, English common law will
prevail over shariah law. This principle was further confirmed in Halpern v Halpern [2006] EWHC
603 (Comm), [2006] All ER (D) 389 (Mar) where Jewish law was not held to be the governing law of
contract in disputes between the disputing parties. But, see the opposite views in Jivraj v. Hashwani,
[2009] All E.R. (D) 272 (Jun) and Musawi v. R.E. International (UK) Ltd., [2007] All E.R. (D) 222
(Dec) quoted by Abdelhady (2009).
30
Also referred to as Investment Account Holders (IAH) by El-Gamal (2006)
31
Even though it is accepted that in the special mudarabah agent/principal relationship, the risk of loss
falls entirely on the rabb al-mal

16

effectively subordinating equity-based investments that would otherwise have

qualified as secured debt under conventional corporate law. Accordingly, all MAH
and IAH holders were treated as ordinary unsecured creditors.
On the liabilities side of Islamic banks in distress, an important secondary
consequence that arises is the question of debt relief to the debtors (the bank in this
case) in the way contemplated for natural persons. The Quran exhorts:

If the debtor is in difficulty, grant him time until it is easy for him to repay
(2:280)
Shariah scholars are generally agreed that in light of this verse, lessening the plight of
debtors is highly meritorious and commendable (al-Qaradawi, 1984, pp. 268-9).
However, the verse cited refers to difficulty presently experienced whereas insolvency
is an ex post event. Further, bank insolvency relates to a juridical person and not a
natural person. As the juridical person status of banking (and corporate) entities
does not exist in fiqh muamalat, its equivalence to the classical waqf adduces to it the
standing of a natural person.32 It follows that a distressed bank may plead for debt
relief through any Shariah acceptable means where onerous debt obligations are not
fulfilled.33 Consequently, MAH and IAH holders in pre-empting insolvency may enter
into compromise arrangements with a bank in arranging debt relief and such
arrangement made an order of court as a means of securing their debt.34 In secular
and non-Islamic jurisdictions, once such opportunity is lost,35 any move to confer
preferential debt ranking ex post would be difficult in subsequent insolvency
proceedings.
However, as mudaraba investors and mindful of risk exposure, this course of
action does not represent the true spirit advocated in Islamic finance, as Vogel and
Hayes (1998,) argue:
In Islam, the notion of a hierarchy of capital supplier is repugnant; the idea of giving
one source of capital a preferential position over others as profits or claims on assets is
not in the spirit of the partnership approach to business structure. The optimal
arrangement is an assemblage of collegial investment partners who all do well if the
enterprise prospers, and who share the pain if the venture stumbles (p. 189). (Emphasis)
32

See Taqi Usmani (1998, pp. 224-225), It seems that the Muslim jurists have treated the waqf as a
separate legal entity and have ascribed to it some characteristics similar to those of a natural person.
33
Through for instance, debt postponement, rescheduling or scheme of arrangement provided none of
these results in any accretion in the face value of the debt.
34
In interviews with third parties it emerged IBL did contemplate some form of debt arrangement
with creditors but that meant effectively losing its banking licence.
35
This was precisely what transpired in the Islamic Bank Ltd case.

17

On the banks asset side, problems arise over debt relief in relation to monies
owed to insolvent banks by clients and third parties (as loans and receivables). As a
rule, once insolvency commences, the liquidator is duty-bound to take all measures to
convert assets into cash for distribution to creditors. Effectively, mudaribs would be
replaced by liquidators and would have no say in the debt collection process. This
commonality prevails in both Islamic and conventional insolvency procedure. AlHafiz Ibn Hajar in his Bulugh al-Maram36 quotes the following hadith with respect to
bankrupt persons:
Kaab ibn Malik narrated that Allahs Messenger (peace be upon him) seized the wealth
of Muadh and sold it in return for a debt he had incurred (Hadith No 730, pp. 279-280).

The general inference from this hadith is the protection of the plight of the creditor
arising from the debtors bankruptcy and the continued erosion of property were the
debtor allowed to continue. Generally, any reduction in receivables or assets has a
corresponding equivalent reduction in money available for distribution to creditors.
Thus, debt relief to debtors would unjustly prejudice MAH and IAH holders.
However, we read in the Mejelle under Article 1002 (Tyser, Demetriades, & Effendi,
p. 157):

Whatever may lead to the destruction of the rights of the creditors, like a gift, alms or the
sale of property for less than the equivalent value [is affected by the prohibition].

The prohibition referred to relates to making disposition of property not for

value, which here includes gifts and alms. At the time IBL was declared insolvent its
receivables amounted to R150.60 million of which R45.66 million was considered
non-performing. It is not difficult to imagine the destruction of the rights of IBLs
creditors through further reductions in receivables. From private interviews, it seems
many IBL debtors did avail themselves of this opportunity.
Other unintended consequences however, emerge from debt collections. The
first is the issue of bank-client relationship. In FirstRand Bank Ltd v Chaucer
Publications 2008 (2) SA 592 (C), it was held that the special relationship between a
bank and its client is one of confidentiality, but that this rule may be overridden in
upholding the greater public interest. This confidentiality rule is a fiduciary duty
36

In The Book of Business Transactions, Chapter 6. titled Bankruptcy and Seizure

18

placed on bank management and one that extends to liquidators. It follows that each
debtor is free to negotiate their debt obligations separately and confidentially, unless
the liquidator establishes different procedures for each class of debtors. The second,
as pointed out earlier, is that Islamic law is superseded by secular law in non-Islamic
jurisdictions37 in liquidation proceedings so that the liquidator is not obliged to apply
Shariah ethics in debt collection. Hence, granting time to the debtor is at the discretion
of the liquidator. The flow-on effect is that, following the decision in Intramed (Pty)
Ltd (in liquidation) v Standard Bank of South Africa Ltd 2008 (2) SA 466 (SCA) the
liquidator may charge interest at tempore morae from the moment the debtor is in
default.38 In general, liquidators would not experience much difficulty in collecting
short-term receivables and may resort to less onerous collection strategies.
Nevertheless, since insolvency is meant to restore solvency quickly to
benefit creditors through liquidating assets, the question arises: what happens to
genuine long-term receivables contracted under murabaha and ijara principles?39
Given such lengthy loan tenures, winding-up may occur over very long periods that
may not be a desirable outcome for creditors. Two methods of addressing this
problem may be by way of (1) debt novation and (2) the sale of receivables. Before
dealing with this question proper, it is essential to remember the Quranic injunction
in al-Maidah (5:1) O you who believe, fulfil your obligations. Scholars agree this
injunction is clear: if you incur debt, you have an obligation to settleyou are not
absolved from your obligations through extraneous circumstances unrelated to your
debt (Doi, 1984; al-Qaradawi, 1989; Kamali, 2004; ISRA Monograph 1, 2009, p. 39).
Thus even when the debts are novated to third parties, the balance owing is the
outstanding value of the sale price as decided in the Malaysian case Arab-Malaysian
Merchant Bank Bhd v. Silver Concept Sdn Bhd [2005] 5 MLJ 210, whereby the bank
was permitted to claim its full investment and profit from the borrowers. The basis for
invoking this rule stems from the Quranic verse 16:90 God commands justice and
fair dealing.
The problem with using mass novation of receivables in bank winding-up is
that, being a tri-partite agreement, novation requires the agreement of all parties to the
37

However, as to governing law in disputations, exceptions do exist as argued by Abdelhady (2009)

quoting the decision in the English case Musawi v. R.E. International (UK) Ltd., [2007] All E.R. (D)
222 (Dec).
38
This rule may well apply in other jurisdictions where shariah law is not the prevailing law.
39
Although IBLs receivables were not separated into periods, one can infer from the Inspectors Report
that much of the outstanding receivables were long-term murabaha contracts.

19

original agreement.40 In practice, this may be difficult to achieve. Further, the

substituted creditor may not be entitled to more than the outstanding value of the
debt.41 Novation then would not be an attractive investment for other financial
institutions unless the liquidator disposes of the receivables at a discount to their
outstanding value. That would effectively be tantamount to a bay al-dayn arrangement
over which there is considerable conjecture (Rosly, pp. 459-464). El-Gamal (2006, p.
104) points out that contemporary juristswith the exception of Malaysiahave
forbidden trading in liabilities and debt. However, Al-Zuhayli (2007, vol.1 p. 80)
argues that the sale of debt to the debtor is valid but that the sale of debt to another
other than the debtor is not permissible. Given this intractable situation, the most
reasonable course of action for a liquidator may be to novate debts (receivables) to
other Islamic banking institutionsif any were to be found.42 This is problematic
especially in non-Islamic countries where Islamic banking is not well developed.
The final implication considered is the issue of serious operational risks within
Islamic banks that has elicited a great deal of attention by regulators (Archer &
Haron, 2007). Operational risks transcend a number of regulatory concerns of which
material malfunctioning detected in IBLs operations was considered serious. As to
what constitutes material malfunctioning, Wiese (1997) explains:

A breakdown in, and overriding of, a non-existence or an inadequacy of a control

procedure system: which has resulted in, or had the potential to result in, material
losses, contingencies or uncertainties; where material means anything that would
influence the correctness of the value or classification of any asset or liability, or the
correctness of the annual financial statements or any statutory return, by more than a
threshold (where the threshold is either a fixed amount specified, or a percentage of
some factor such as net shareholders funds or profit after tax) (p. 4).

Other findings notwithstanding, material malfunctioning was apparent in the IBL case
for all the consequences discussed in this paper.

Conclusion

The evidence presented in this paper shows that the collapse of the Islamic Bank Ltd
commenced relatively early since inception. It shows that IBL was in breach of its
40

See argument by Mohamed Ismail Mohamed Sharif, ISRA Monograph No.1, pp. 18 et seq.
Ibid
42
The attraction to the acquiring bank would be a host of new clientele.
41

20

Shariah obligations in terms of its financing activities and its offering of Islamic
financial services. Further, despite regulatory breaches, the authorities held back on
remedial action knowing the inherent problems within the bank for reasons other than
prudential regulation. Serious impairment of loans and receivables seriously
undermined the banks liquidity. Compounded with noise and adverse publicity, the
bank soon experienced an unabated run on funds. Finally, the banks external auditors
displayed a gross dereliction of duty by not reporting on the true extent of the IBLs
financial position for each year of its existence.

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